U.S. investors who enjoyed strong third quarter equity returns were dealt a change in market landscape this week. While history has demonstrated a low correlation between equities and U.S. government bonds – exactly the reason why Treasuries are such an important diversifier of equity risk -- this week proved to be an exception. Stock and bond prices both fell following news that the U.S. and Canada had reached agreement about modifying trade terms in North America. As the chart below shows, rates on benchmark U.S. 10-year Treasury notes moved materially higher on the week, reaching levels not seen since 2011.

Source: FactSet

Healthy Reflections

This week’s move in rates brings the 10-year U.S. Treasury yield to just about the midpoint of the range we have been forecasting for year-end. Importantly, we believe that higher rates are occurring for the right reason – a strong U.S. economy whose expansion is verging on the longest ever, creating a virtuous backdrop for corporate earnings. While core inflation has finally risen to the 2 percent level targeted by the Fed, we do not see key wage and unit labor cost data pointing to a worrisome acceleration of prices. Accordingly, we expect the Fed to continue in its measured pace of interest rate hikes meant to bring short-term rates up to a more neutral level.

Help Wanted!

In addition to news on the trade front, investors also paid close attention to today’s monthly employment report for September. A subdued 134,000 net gain in payrolls came in substantially below consensus expectations, but this was most likely the result of last month’s Hurricane Florence. Given the weather disruption, an arguably more important statistic was the monthly wage numbers, which showed stable year-over-year growth of 2.8 percent. Although wages are climbing amid a 49-year low unemployment rate of 3.7 percent, we see unit labor costs being held in check by improving productivity.

Dawn of a New Earnings Season

Turning to earnings, this week brought the first third quarter report for a company with a September quarter-end. Pepsi reported better than expected sales and earnings, but the stock retreated on management guidance for 2018 profit growth that fell slightly below expectations, the result of a stronger dollar reducing the translation of profits earned overseas. Indeed, with the trade-weighted dollar now up 4 percent year-to-date, we will be paying increasingly-close attention to how a stronger greenback impacts the earnings outlook.